SUKUK (ISLAMIC BOND) AN ANALYSIS ON THE APPLICATION OF ISLAMIC

FINANCIAL CONTRACTS

Abstract
Islamic securities (sukuk) are hybrid securities bearing features of stocks and bond, altogether.
Similar to stocks, the indicate a type of partnership and holders of sukuk will be considered as
the owners of underlying asset or project for finance of which sukuk have been issued.
Theoretically, these holders share any loss and profit resulted from underlying asset. However,
these securities usually bear a maturity date like bonds and contrary to stocks. The holder has no
voting right or control over the underlying asset. In case of bankruptcy and contrary to the
shareholder, holder benefits from priority right over underlying asset, in comparison to other
creditors. Practically and contrary to the initial theory in consideration of sukuk (sharing in loss
and profit), nowadays some of these securities are usually of fixed revenue and probable risk
resulting from decrease being made in the value of underlying asset will be covered by the issuer
or originator, through insurance companies. Nowadays new form of sukuk such as convertible,
preference, subordinated and perpetual sukuk have been developed, features of which are very
similar to hybrids. Considering special nature of Sukuk, indicating partial ownership of its holder
over related underlying asset or project, somehow we may use these new hybrid tools to prevent
prevailing risks related to other securities and hybrids, such as credit and bankruptcy risks; and,
we may use them more in financing and attracting capital, globally.

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Introduction
Sukuk are financial instruments similar to bonds and also shares that are compliant with Islamic
law. Since their inception in 2002, Sukuk markets have experienced dramatic growth rates
attracting the attention of investors, analysts and researchers alike. Accounting and Auditing
Organization for Islamic Financial Institutions (AAOIFI) defines Sukuk as being: “Certificates
of equal value representing undivided shares in the ownership of tangible assets, usufructs and
services or (in the ownership of) the assets of particular projects or special investment
activities.”1 There are three requirements for a Sukuk to be considered in compliance with the
Sharia law. First, the certificates must represent ownership in tangible assets, usufructs or
services from revenue-generating firms. Second, payments to the investor come from after-tax
profits and third, the value repaid at maturity date should follow the current market price of the
underlying asset and not the original invested amount. Sukuk comes in many different forms, as
financiers are not restricted to create their own variations, however, fundamentally the parties
within a Sukuk issuance are the firm the obligor or originator, the Special Purpose Vehicle and
the investors that buy the Sukuk. The SPV is a bankruptcy-remote entity, separate from the
originator, which issues Sukuk certificate.

Sukuk (Islamic securities) are considered as Islamic financial instruments created for middle and
long term financing due to some limitations existing in Islamic financial system, resulting in lack
of use of common bonds. These instruments are very similar to common bonds; however, there
are some differences also between the two and in some cases they bear characteristics of stocks.
This has resulted in Sukuk (Islamic securities) to be (probably) considered as a type of hybrid
financial instrument. Outside Islamic financial system, hybrid instruments are considered as one
of the prevailing and common types of securities. These instruments are divided into several
categories, each of which having characteristics of both bonds and stocks. Considering the point
that Sukuk are not specifically used in Islamic markets and they are also applicable in other
capital markets as a financing tool, in this paper, Sukuk will be introduced and compared with
prevailing securities in non-Islamic systems.

Sukuk also proved to be implemented during the economic downturn, or seeks to develop an
economy. For example sukuk or Islamic bond is issuance by the World Bank in 2005 for the
redevelopment of Acheh following the tsunami and The Kuala Lumpur International Airport in

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Sepang, Malaysia through which many foreign delegates arrived here today, was financed by
sukuk in 1996. (Zeti Akhtar, 2007) Nowadays sukuk or Islamic fixed-income securities that have
emerged over the past 15 years become as an increasingly important asset class. These products
have a number of objectives which is to enable organizations to raise capital in a Shariah-
compliant fashion, whilst at the same time expanding the investor base and offering investment
opportunities to new groups. Considering their relative infancy, Islamic securities can be
structured in a number of increasingly complex ways. Indeed, new products are being
consistently developed and introduced. Therefore, it is essential to remain conversant with the
important principles of structuring Islamic securities.

Sukuk may be defined as certificates of equal value that represent an undivided interest
(proportional to the investor’s interest) in the ownership of an underlying asset (both tangible and
intangible), usufruct, services or investments in particular projects or special investment
activities. Through this concept, sukuk enjoy the benefit of being backed by assets, thereby
affording the sukuk holder or investor a level of protection which may not be available from
conventional debt securities. Furthermore, unlike conventional debt securities that mirror debts
or loans on which interest is paid, sukuk can be structured based on innovative applications of
Islamic principles and concepts. Nonetheless, sukuk share some similarities with conventional
debt securities, in that they are similarly structured based on assets that generate revenue. The
underlying revenue from these assets represents the source of income for the payment of profit
on the sukuk. (Malaysia Debt Securities and Sukuk Market, 2009)

SUKUK AL- MUDARABAH

(A partnership in profit whereby one party provides capital (rab al-maal) and the other provides
labour (mudarib)

Mudarabah refers to a form of equity-based partnership in which one party (the rab al-maal)
provides the other party (the mudarib) with capital and the mudarib uses its expertise and labour
to invest the capital in return for a pre-agreed share of the profit generated.

In the context of sukuk, an SPV is usually established to issue the sukuk and contribute the
proceeds raised from the investors as mudarabah capital (and therefore the SPV issuer becomes
the rab al-maal). The originator of the sukuk contributes expertise, labour and possibly cash,

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serves as mudarib and manages the capital. Any profits generated by the mudarabah are divided
between the rab al-maal and the mudarib in accordance with agreed profit-sharing ratios set out
in the mudarabah agreement. The SPV uses the profits it receives from the mudarabah to make
payments of the periodic distribution amounts due under the sukuk. Prior to the AAOIFI
Statement, sukuk al-mudarabah structures typically included a purchase undertaking in favor of
the SPV, allowing for the purchase of the rab al-maal’s interest in the mudarabah for a pre-
agreed exercise price. This exercise price was structured to ensure that the rab al-maal received
the amount required to pay the dissolution distribution amount due to investors under the sukuk.
Since the AAOIFI Statement, scholars have taken the view that an originator may not grant a
purchase undertaking for any amount other than the market value of the rab al-maal’s interest in
the mudarabah assets at the time of sale (on the basis that determining the value by reference to
the value of the sukuk is akin to a guarantee of profit and principal which, unless given by an
independent third party, is not permitted under Shari’ah). While the inability to grant such a
purchase undertaking has contributed to the decline of the mudarabah structure for sukuk, the
structure recently has experienced a revival with the introduction of the sukuk as a method of
increasing Tier 1 and Tier 2 regulatory capital for banks and financial institutions.

Shari’ah Requirements Applicable to the Underlying Mudarabah

The arrangement in a mudarabah structure must comply with the general Shari’ah requirements
applicable to mudarabah agreements:

 A mudarabah contract may be unrestricted or restricted. Under an unrestricted mudarabah

contract, the rab al-maal, the issuer SPV, permits the mudarib, the originator, to
administer the mudarabah capital without any restrictions. The mudarib must exercise
this freedom in accordance with the interests of the parties and the business contract,
hence, with a view to making profit. Under a restricted contract, the rab al-maal imposes
certain restrictions on the mudarib, however, not to the extent that the mudarib will be
unduly constrained in his operations.
 In principle, the capital for the mudarabah must be provided in cash; however, it may be
provided in the form of tangible assets with the value of such assets constituting the
mudarabah capital. At least 33 percent of the capital should be invested in actual tangible
assets in accordance with Shari’ah.

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  The mudarib must have free access to the capital for the mudarabah to be considered
valid
 The profit-sharing ratio should be determined in advance and must be a percentage of the
actual profit, not a percentage of the capital or a lump sum.
 However it is permissible to stipulate that if the profit is above a certain ceiling (up to
which the profits are shared according to pre-agreed ratios) one party may take that
additional profit.
 Any losses of the mudarabah enterprise will be borne by the rab al-maal but the rab al-
maal is liable only to the extent of the proceeds invested. Sukuk investors will therefore
be liable only for their invested proceeds.

STRUCTURE OF SUKUK AL MUDARABAH

Overview of Structure:

1. Issuer SPV issues sukuk, which represent an undivided ownership interest in an

underlying asset or transaction. They also represent a right against Issuer SPV to payment
of the Deferred Price.

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 2. The Investors subscribe for sukuk and pay the proceeds to Issuer SPV (the “Principal
Amount”). Issuer SPV declares a trust over the proceeds (and any commodities acquired
using the proceeds – see paragraph 3 below) and thereby acts as Trustee on behalf of the
Investors.
3. Originator (as Purchaser) enters into a murabahah agreement with Trustee (as Seller),
pursuant to which Trustee agrees to sell, and Originator agrees to purchase, certain
commodities (the “Commodities”) from Trustee on spot delivery and deferred payment
terms. The period for the payment of the deferred price will reflect the maturity of the
sukuk. Trustee purchases the Commodities from a third party Commodity Supplier for a
Cost Price representing the Principal Amount for spot payment.
4. Commodity Supplier makes spot delivery of the Commodities to Trustee in consideration
for the Cost Price.
5. Trustee (as Seller) on-sells to Originator the Commodities upon delivery from
Commodity Supplier in accordance with the terms of the murabaha agreement
6. Originator (as Purchaser) makes payments of deferred price at regular intervals to Trustee
(as Seller). The amount of each deferred price instalment is equal to the returns payable
under the sukuk at that time.
7. Issuer SPV pays each deferred price instalment to the Investors using the proceeds it has
received from Originator.

Sukuk al mudarabah in maybank

The Issuer proposes to establish the Sukuk Programme which shall provide flexibility for the
Issuer to issue, from time to time, Sukuk Murabahah during the tenure of the Sukuk Programme,
provided that the aggregate outstanding amount of the Sukuk Murabahah shall not at any time
exceed RM10.0 billion in nominal value. The Issuer shall have the option to upsize the Sukuk
Programme limit provided that (a) such upsizing will not result in any adverse impact on the
rating of the Sukuk Programme, (b) the relevant requirements under the LOLA Guidelines in
relation to such upsizing has been complied with, and (c) the relevant regulatory approvals have
been obtained (if applicable). Pursuant to the Trust Deeds, no further consent is required to be
obtained from the Sukuk Trustee, the Sukukholders or any other party under the Sukuk
Programme for the Issuer to exercise the option to upsize the Sukuk Programme limit.

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The Subordinated Sukuk Murabahah constitute direct, unconditional, unsecured and
subordinated obligations of the Issuer and shall at all times rank pari passu and without any
preference among themselves and with all other present and future Subordinated Indebtedness
(as defined below) of the Issuer, except those preferred by law. The Senior Sukuk Murabahah
constitute direct, unconditional, unsecured and unsubordinated obligations of the Issuer and shall
at all times rank pari passu and without any preference among themselves and with all other
present and future unsecured and unsubordinated obligations of the Issuer, except those preferred
by law.

SUKUK AL MUSHARAKAH

“A form of partnership between the Islamic bank and its clients whereby each party contributes
to the capital of the partnership in equal or varying degrees to establish a new project or share in
an existing one, and whereby each of the parties becomes an owner of the capital on a permanent
or declining basis and shall have his due share of profits”

Musharakah is derived from the Arabic word Shirakah, which means partnership. A musharakah
arrangement entails the contribution of capital (either in cash or in kind) by two or more partners to the
partnership. The musharakah partners share the profits in prearranged ratios. Any profits generated in
excess of the level of profits required to enable the issuer to make the relevant payments to sukukholders
are typically paid into a cash reserve for disbursement to sukukholders in the event that profits for a
period are insufficient to cover the periodic distribution amount.

Shari’ah generally recognizes two broad categories of partnerships; (i) sharikat al-’aqd (a contractual
partnership) and (ii) sharikat al-melk (a property partnership). In the context of sukuk issuances, the
sharikat al-’aqd entails an agreement between the originator and the trustee to combine their assets, labor
or liabilities, while the sharikat almelk entails a transaction that results in the originator’s and the trustee’s
joint ownership of an asset. When deciding between structuring a sukuk based on sharikat al-’aqd or
sharikat al-melk, it is necessary to identify the nature of the originator’s business and whether any assets
exist to support the issuance of a sukuk. If no tangible asset exists that could be contributed to the
partnership in compliance with Shari’ah, the sharikat al- ’aqd structure may be the better choice.

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While sukuk al-musharakah was previously one of the more commonly used structures, use of the
musharaka has declined since the AAOIFI Statement, since Shari’ah scholars now take the view that it is
not permissible for an originator to grant a purchase undertaking to the trustee to purchase the musharaka
assets for any amount other than the market value of the trustee’s interest in the musharaka assets at the
time of sale (on the basis that both partners should take the risk of both profit and loss). This inability to
guarantee the return of the sukukholders’ initial investment through an undertaking to redeem the sukuk
at face value has reduced the popularity of the structure

Shari’ah Requirements Applicable to the Underlying Musharakah

The underlying musharakah in a sukuk al-musharakah structure must comply with the general
Shari’ah requirements applicable to partnerships:

 The profit-sharing ratios of each partner must be determined in advance.

 The profit-sharing ratios may be in proportion to the percentages of each partner’s

capital contribution but partners may also agree to share profits in a manner that is
not proportionate to their capital contributions, provided that an additional
percentage of profit beyond the percentage of the contribution is not in favor of a
sleeping partner.
 Stipulations to the effect that any partner’s profit will constitute a lump sum or a
percentage of the capital of the partnership are void.
 It is permissible to set aside surplus profit in a reserve account to fund any
shortfalls in future periodic distribution amounts or in the exercise price.
 Any losses of the partners must be proportionate to their respective capital
contributions.
 The musharakah assets must comprise between 33 percent and 50 percent tangible
assets, depending on the consulting Shari’ah scholars’ views.
 Any partner may terminate the musharakah by giving notice to the other partner

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  Upon termination, any tangible assets that form part of the musharakah will be
liquidated and distributed together with the intangible assets to the originator and
the trustee in proportion to their respective capital contributions, or units held in
the musharakah.

Structure of Sukuk al-Musharakah (based upon a shirkat al-aqd arrangement)

Overview of Structure

Trustee will sell, and Originator will buy, all of Trustee’s units in the musharaka at the applicable
Exercise Price, which will be an amount equal to the Trustee’s share in the fair market value of
the Musharaka Assets at the time of sale. The Exercise Price will be used to pay the Principal
Amount plus any accrued but unpaid Periodic Distribution Amounts owing to the Investors.

Pre-AAOIFI’s Statement, the Exercise Price was often fixed at the outset to be an amount equal
to the Principal Amount plus any accrued but unpaid Periodic Distribution Amounts owing to the
Investors. However, following on from the AAOIFI Statement the general Shari’h position is
that where the Originator and the purchaser under the Purchase Undertaking are the same entity,
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the Exercise Price cannot be fixed in this manner and must instead be determined by reference to
the market value of the Musharaka Assets at the time of sale (please see the section below under
the heading “AAOIFI’s Statement of 2008” for further information). As a result of this, there is a
risk that the Exercise Price will be less than the amount required to pay the Principal Amount
and all accrued but unpaid Periodic Distribution Amounts owing to the Investors. In order to
mitigate this risk, additional structural enhancements can be incorporated into the structure
including (i) the maintenance of a reserve account into which excess profits from time to time
during the life of the sukuk are held and used to make up any shortfalls in any payments due to
Certificate-holders; and/or (ii) the option of a third party providing Shari’a-compliant liquidity
funding to fund any shortfalls in any payments due to certificate-holders (see the section below
headed “Key features of the Underlying Structure” for further detail). These mitigates do not
however address all the risks associated with an exercise price linked to market price of the
assets.

Liquidity Facility in the event of shortfall in Sukuk Musharakah maybank

Another issue to be discussed is liquidity facility in equity based Sukuk such as Sukuk
Musharakah. In this regard, the manager who is also a partner in the Musharakah venture
undertakes to make good the difference between the actual income generated and the
indicative/expected return based on Shariah principle of qardh. Thereafter such an amount will
be reimbursed or set-off against the subsequent actual income generated (if there is excess over
the indicative return) or the exercise price to be paid to the Sukukholders upon dissolution of
Sukuk Musharakah. Many Shariah scholars criticize this practice, including Sheikh Taqi uthmani
who opines that that such commitment and obligation by the issuer/manager in covering
shortfalls in the expected return for periodic distribution of profit will come under the heading of
a sale with credit which was prohibited by the Prophet (peace be upon him).

The AAOIFI Shariah Board disapproves the practice of giving loan by the manager to
Sukukholders to cover the shortfall. They argue that this act is equivalent to guaranteeing the
expected return which violates the nature of Musharakah which is based profit-loss sharing.
Alternatively, in order to address this concern, AAOIFI is suggesting an alternative solution by
way of the establishment of a ‘reserve account’ for the purpose of covering such shortfalls and

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the establishment should be mentioned in the prospectus. The pronouncement issued by AAOIFI
in this matter as below stated,

“It is not permissible for the manager of Sukuk, regardless of whether the manager acts as a
mudarib (investment manager), or a sharik (partner), or a wakil (an investment agent), to
undertake to offer loans to Sukuk holders when actual earnings fall short of expected earnings. It
is permissible, however, to establish a reserve account for the purpose of covering such shortfalls
to the extent possible, provided the same is mentioned in the prospectus.”

The operationalization of the reserve account is different from loan top-up. The reserve account
contains the excess amount over the expected return which has been waived by the
Sukukholders. Hence, in the case of shortfall, the reserve amount will be used to cover such
difference. Based on this practice, one may argue that this is not a pure guarantee as the amount
in the reserve account is the ‘real’ return from the business venture to begin with. On the other
hand, the Shariah Advisory Council of Securities Commission is of the view that the issuer is
allowed to make advance payment to meet the expected return since there is no guarantee issue
because the payment will be deducted or set off from the Exercise Price.41 Furthermore, to
deduction/set off does not entail any additional amount, which is tantamount to riba. In some of
Sukuk structures, it combines both approaches. It means, if there is any shortfall, the difference
will be covered by the reserve account. If the reserve account is insufficient to make good the
difference, the manager undertakes to advance its own money to top-up the shortfall on the qardh
basis.

Issues highlighted by Taqi Usmani and AAOIFI, the other issues which are related to
sukuk are as follows:-

a. High costs of financing:

Sukuk are extremely difficult instrument to structure as they require extensive and costly legal
and religious advice and a lot of different skills and resources to make it work. The development
of new products and financial engineering are resource-intensive activities as it involves the
conduct of market research, product development and analytical modeling. These activities
demand financial and human resources which are costly. On the other hand, Islamic financial

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institutions are generally of small size and may not have the budget for research and
development. Further, there is uncertainty with regards to the perceived risk associated with the
instruments. This is why many corporations and banks shy away from this instrument. It has
been suggested that Islamic financial institutions should seriously consider joining efforts to
develop the basic infrastructure for new products, given the importance of financial engineering.

b. Lack of trading at the secondary market:

Although sukuk can be negotiated and traded freely in the market, it remains active merely at the
primary market. This is because most holders keep sukuk to maturity and many sukuk are held
by large institutions so that the assets are unavailable for the average private investors. The lack
of active trading at the secondary market is also due to the limited number of issuances and the
lack of alternative instruments in this asset class36. Moreover, sukuk are out of reach for the
average investors and its holders are normally the wealthiest Muslim investors due its huge
trading size. This may defeat the higher purpose that Islamic finance aims to achieve – fair and
equal distribution of wealth among the people. According to the contemporary scholars and the
Organisation of the Islamic Conference (“OIC”) Islamic Fiqh Academy’s ruling, sale of debt is
permissible so long as it is free from any element of riba and gharar41. Following such ruling, it
is pertinent to determine the nature and status of the debt42. If the receivables of the debt are in
the monetary form, the debt is considered as similar to money and the rules in the exchange of
money will apply. This means the transaction will have to adhere to the rule of parity and it must
be carried out on the spot. If the receivables are in the forms of non-ribawi goods, it is considered
as a non-monetary financial right and the rules in the exchange of money or ribawi items will not
apply43. Notwithstanding the above ruling by OIC Islamic Fiqh Academy, the Shariah Advisory
Council of the Malaysian Securities Commission (“SACSC”) has departed from the rule of
parity in allowing sale of debt with a discount. This is because the nature of the debt has changed
after it has been securitised. Therefore, it is no longer governed by the rule on currency exchange
and the practice of discounting in the sale of debt is allowed.

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Conclusion

As observed, Sukuk are considered as Islamic securities which hold characteristics of both stocks
and securities together, like other hybrid securities. Introduction of Sukuk and comparing them
to common bonds and company stocks were studied in different sections of the paper. At the end,
we came to the result that Sukuk are a new type of hybrid securities; and, comparing some new
models of Sukuk with various hybrid securities, we mentioned that “as hybrids consisting of
various types such as convertible bonds, preference shares, subordinated bonds, perpetual bonds
and knock-out bonds, Sukuk also are of various modern types in addition to their common and
simple type, which could be cited as convertible, preference, subordinated and perpetual Sukuk.
Furthermore, unlike conventional debt securities that mirror debts or loans on which interest is
paid, sukuk can be structured based on innovative applications of Islamic principles and
concepts. Nonetheless, sukuk share some similarities with conventional debt securities, in that
they are similarly structured based on assets that generate revenue. The underlying revenue from
these assets represents the source of income for the payment of profit on the sukuk. (Malaysia
Debt Securities and Sukuk Market).

Mudarabah refers to a form of equity-based partnership in which one party (the rab al-maal)
provides the other party (the mudarib) with capital and the mudarib uses its expertise and labor to
invest the capital in return for a pre-agreed share of the profit generated. . This exercise price was
structured to ensure that the rab al-maal received the amount required to pay the dissolution
distribution amount due to investors under the sukuk. Since the AAOIFI Statement, scholars
have taken the view that an originator may not grant a purchase undertaking for any amount
other than the market value of the rab al-maal’s interest in the mudarabah assets at the time of
sale (on the basis that determining the value by reference to the value of the sukuk is akin to a
guarantee of profit and principal which, unless given by an independent third party, is not
permitted under Shari’ah). Musharaka is derived from the Arabic word Shirakah, which means
partnership. A musharaka arrangement entails the contribution of capital (either in cash or in kind) by two

13
or more partners to the partnership. The musharaka partners share the profits in prearranged ratios. Any
profits generated in excess of the level of profits required to enable the issuer to make the relevant
payments to sukukholders are typically paid into a cash reserve for disbursement to sukukholders in the
event that profits for a period are insufficient to cover the periodic distribution amount.

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